Details

Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 24 May 2011

By Sidney Kess, CPA, J.D., LL.M & Christopher M. Ferguson, J.D.

On February 8, 2011, the IRS announced that it had instituted a second offshore voluntary disclosure compliance program, the 2011 Offshore Voluntary Disclosure Initiative (the “2011 OVDI” or the “Program”); available to all taxpayers with previously undisclosed offshore assets. Similar to the IRS’s earlier 2009 Offshore Voluntary Disclosure Program (the “2009 OVDP”), which closed on October 15, 2009, the new Program is intended to afford those taxpayers — who, for whatever reason, failed to avail themselves of the 2009 OVDP — an opportunity to become compliant with U.S. tax laws. The 2011 OVDI is a significant opportunity for taxpayers who still hold undisclosed foreign accounts. However, taxpayers who wish to participate must follow very explicit procedures for doing so. In addition, the costs of participating in this new Program can be significant and are not always apparent. Therefore, it is imperative that practitioners who are advising taxpayers with undisclosed foreign assets become familiar with the new Program and its requirements.

Why Did the IRS Institute the 2011 OVDI?

The IRS wants to capitalize on a number of factors that it believes will incentivize additional taxpayers to become compliant with the law by disclosing their foreign accounts. These factors include:

• The publicity and what the IRS perceives as the success of the 2009 OVDP;
• Additional developments in the law and in international enforcement -- such as the passage of the Foreign Account Tax Compliance Act (FATCA) and the relaxation of restrictions on obtaining foreign bank information in the U.S. government’s tax treaty with Switzerland.
• Recent law enforcement successes, such as the Justice Department’s announcement of its intent to issue “John Doe” summonses to HSBC in India seeking information on HSBC’s U.S. account holders, as well as rumors of a similar initiative targeted at Credit Suisse customers.

At the same time, the new Program reflects the IRS’s recognition that, notwithstanding its recent law enforcement successes, voluntary compliance remains the most effective way for the IRS to achieve its mission of closing the tax gap. The new Program therefore reflects a continuation of the IRS’s carrot-and-stick approach to fostering compliance. It seeks to capitalize on the notoriety that the 2009 Program achieved, as well as the IRS’s newly enhanced enforcement arsenal, to entice those who still remain in hiding to come forward under what is effectively a last chance opportunity for a reduced penalty.

Who Should Participate?

Any taxpayer with undisclosed foreign accounts or assets who is not already subject to a civil examination or criminal investigation is eligible to participate and should strongly consider doing so in light of the risks involved in failing to come forward. The mere fact that the IRS has served a John Doe summons on an institution that ultimately will lead to the IRS learning the taxpayer’s identity as having an undisclosed foreign account does not disqualify the taxpayer from participating.

Even those taxpayers who are ineligible to participate in the Program due to pendency of an exam or investigation should consider coming forward. Although the civil penalties imposed on such taxpayers will no doubt be more onerous than those offered under the Program, depending on the circumstances, the taxpayer may be able to substantially reduce the risk of a criminal prosecution by coming forward voluntarily.

Who Should Not Participate?

Generally speaking, the voluntary disclosure program is only for taxpayers who willfully failed to disclose, and/or pay tax on, foreign assets. Taxpayers whose conduct was non-willful, or who did not fail to report income, may not need to avail themselves of the Program, although they should protect themselves by correcting past non-willful violations.

For instance, the IRS has stated that taxpayers who failed to file Form TD F 90-22.1 (the “FBAR”) reporting a foreign account, but who reported and paid tax on the income from that account, should not make a voluntary disclosure.

Instead, such taxpayers are instructed to simply file the delinquent FBARs with the Service by August 31, 2011, in which case no penalties will be imposed.

Why Should a Taxpayer File?

As noted previously, the international climate has become increasingly less hospitable to bank secrecy. For instance, on March 18, 2010, President Obama signed into law the Foreign Account Tax Compliance Act (FATCA). Part of the Hiring Incentives to Restore Employment (“HIRE”) Act, FATCA imposes new reporting obligations on any taxpayer who “holds any interest” in a “specified foreign financial asset” where the aggregate value of all such assets exceeds $50,000. The information must be provided as part of the taxpayer’s personal income tax return. This obligation is in addition to, not in lieu of, the obligation to report foreign account information on the FBAR on or before June 30 each year. In addition, beginning in 2013, FATCA will require all foreign financial institutions to provide information on all U.S. taxpayers holding accounts with the institution, or face onerous penalties.

Also, the government has seen its enforcement arsenal expand over recent years. For instance, in September 2009 the U.S. and Swiss governments executed a Protocol amending Article 26 of the Tax Convention between both parties. Among other things, the amendments enhance the U.S. government’s ability to receive banking information with respect to U.S. accountholders when certain threshold requirements are satisfied. Citizens also have been availing themselves of the Internal Revenue Code’s whistle-blower statute at an increasing rate. The law permits the government to pay monetary awards to whistle-blowers who provide information leading to the collection of additional taxes from non-compliant taxpayers, subject to certain requirements.

As these developments illustrate, and as Commissioner Shulman has stated, the momentum in international banking is unmistakably toward greater transparency, and this trend does not appear likely to reverse itself. These waters are increasingly perilous for someone who continues to conceal their assets abroad. Not only does this climate increase the likelihood of getting caught, but it also forces taxpayers who remain non-compliant to invent even more elaborate artifices to conceal their assets, making it even harder to access those monies.

In addition, besides the risk of criminal prosecution, the civil statutory penalties, which may be imposed for failing to report overseas assets, can be economically ruinous. For instance, the statutory penalty for willfully failing to file an FBAR is the greater of $100,000 or 50 percent of the highest aggregate balance of all undisclosed accounts for each violation. Thus, after two years of non-compliance, the statutory penalties may wipe out a taxpayer’s entire account. Although the terms of the 2011 OVDI certainly exact a price, for many taxpayers, that price looks much more attractive when compared to the increased risks, and high price, of apprehension.

What is the Deadline for Participation?

The 2011 OVDI expires on August 31, 2011. What this deadline entails differs considerably from the 2009 OVDP deadline. The 2009 OVDP deadline of October 15, 2009 was a deadline only for seeking entry into the Program. There was no specific deadline imposed for taxpayers to meet their civil requirements under the Program.

By contrast, taxpayers seeking to participate in the 2011 OVDI must complete the civil requirements of the Program by August 31, 2011, including submitting amended tax returns reporting all foreign income and filing all appropriate forms (such as FBARs or other applicable forms), by that date.

Completing these requirements can be a time consuming process, especially when overseas account information is not immediately available. Accordingly, practitioners with clients who continue to remain on the fence about participating in the Program should advise their clients that waiting any longer could jeopardize their ability to comply in a timely fashion with the Program’s requirements.

What are the Terms and Costs of the 2011 OVDI?

Taxpayers who wish to participate in the 2011 OVDI must:

• File amended tax returns reporting all worldwide income dating back to 2003 and pay all additional tax owed on those amended returns. For taxpayers whose accounts include holdings in passive foreign investment companies (PFICs) the amended returns must include a calculation of PFIC income. The terms of the 2011 OVDI contain an alternative method for calculating PFIC income that participating taxpayers may elect to use. The alternative PFIC procedures can be found with the IRS’s “Frequently Asked Questions and Answers.”
• Pay an accuracy-related (or delinquency) penalty of 20 percent of the additional tax owed dating back to 2003, pursuant to IRC § 6662(a).
• If applicable, pay failure to file or failure to pay penalties under IRC §§ 6651(a)(1)-(2);
• Pay statutory interest on the additional tax and penalties.
• Pay a one-time miscellaneous penalty (in lieu of all other applicable reporting penalties) of 25 percent of the highest aggregate balance of all foreign accounts for the period covered by the voluntary disclosure. It should be noted that, included in the calculation of the miscellaneous penalty is the value of the taxpayers’ interest in all other foreign assets (e.g., real estate, corporations) as to which the taxpayer was non-compliant with U.S. tax law. This can be a significant “hidden” cost of the program for some taxpayers.

Notwithstanding the imposition of a 25 percent penalty, the IRS continues to maintain that taxpayers will not be made to pay in excess of what they would otherwise be required to pay under applicable law outside the parameters of the Program. However, in determining the applicable penalty outside the Program, examiners are directed to calculate the applicable penalties at their maximum levels and without regard to mitigating factors such as reasonable cause or non-willfulness. Under such circumstances, instances in which the applicable penalties would be lower outside the Program’s penalty framework will be exceedingly rare.

What are the Procedures for Participation?

Taxpayers who wish to make a voluntary disclosure must:

• Prepare and submit complete and accurate amended tax returns for the voluntary disclosure period (i.e., 2003-2010) with schedules detailing the nature and amount of previously unreported income.
• Provide copies of the taxpayers’ original tax returns for the disclosure period.
• Provide complete and accurate original or amended FBARs for the voluntary disclosure period.
• Prepare and submit a completed Foreign Account or Asset Statement (a copy of which can be found on the IRS Web site at http://www.irs.gov/pub/irs-utl/2011ovdiforeignaccountstatement.pdf) for each undisclosed account or asset.
• Prepare and submit a Foreign Institution Statement (a copy of which can be found on the IRS Web site at http://www.irs.gov/pub/irs-utl/2011ovdifinancialinstitutionstatement.pdf). This requirement only applies to taxpayers disclosing accounts with aggregate highest balances in excess of $1 million in any given year.
• If applicable, prepare and submit any other required schedule or form related to the taxpayer’s ownership of the foreign account or asset for the voluntary disclosure period, such as Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts); Form 3520-A (Information Return of Foreign Trust with a U.S. Owner); Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations); Form 5472 (Information Return of a 25 percent Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business); Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation); and Form 8865 (Return of U.S. Persons with Respect to Certain Foreign Partnerships).¹
• Obtain account statements from each foreign financial institution. For taxpayers disclosing accounts with aggregate highest balances exceeding $500,000, those statements must be provided by August 31, 2011. Taxpayers disclosing accounts with aggregate balances of less than $500,000 must have the statements available on request.
• Execute requested extensions of the statute of limitations for assessment of tax and FBAR penalties for the voluntary disclosure period.

Any participant in the Program must cooperate fully with the IRS with respect to the voluntary disclosure process in general. This entails providing information to the IRS concerning the taxpayer’s offshore banking activities (including the identities of facilitators), if requested. It also entails executing a closing agreement with respect to all years covered by the voluntary disclosure period and paying all tax, penalties and interest due or, if the taxpayer qualifies to do so, entering an agreement to pay the liability over time.

How Does a Taxpayer Gain Entry Into the Program?

The procedures for initiating a voluntary disclosure have become more streamlined under the 2011 OVDI. A taxpayer initiates a voluntary disclosure under the 2011 OVDI by mailing an Offshore Voluntary Disclosure Letter, a sample of which can be found on the IRS’s Web site at www.irs.gov/pub/irs-utl/2011-ovdi-irs-ci-letter-01-31-2011.doc, to Offshore Voluntary Disclosure Coordinator, 600 Arch Street, Room 6404, Philadelphia, PA 19106.

The new Program also offers taxpayers the opportunity to be pre-cleared by the Criminal Investigation Division prior to making a voluntary disclosure. A taxpayer does so by faxing his or her name, date of birth and social security number to the Criminal Investigation Lead Development Center (LDC) at (215) 861-3050.

What are the Benefits of Participation?

The primary benefit of participating is the assurance that the IRS Criminal Investigation Division will not recommend the taxpayer’s matter for criminal prosecution, which, for all intents and purposes, means the taxpayer will not be prosecuted. On the civil side, one of the benefits of participating is the promise that the IRS will look back no further than 2003. Otherwise, the IRS could look back for as long as the taxpayer held the undisclosed account, since the civil statute of limitations for assessment does not expire with respect to a fraudulent return. The other principal economic benefits of participating consist of the otherwise statutorily applicable penalties that the IRS agrees to forego in exchange for the taxpayer’s compliance with the terms of the Program. These include, without limitation:

• Civil fraud penalties under IRS §§ 6663 or 6651(f) comprised of 75 percent of the underpayment of tax.
• A penalty for failing to file Form TD F 90-22.1 (the FBAR form), which is the greater of $100,000 or 50 percent of the highest aggregate balance in the undisclosed accounts for each year of non-compliance.
• Penalties for failing to file various information returns, if applicable. For instance, the penalty for failing to file Forms 5471 or 8865 are $10,000 for each return that was not filed, while the penalty for failing to file Form 3520 is 35 percent of the gross reportable amount on the return or, in the case of gifts, 5 percent of the gift amount per month, not to exceed 25 percent of the total gift amount.

How Does This Program Differ From the 2009 OVDP?

In addition to modifying some of the voluntary disclosure procedures to make them more streamlined, some of the key differences between this Program and the 2009 Program are as follows:

• Additional Years Covered. The 2011 OVDI covers more years than its predecessor. Whereas the 2009 OVDP was expressly a six-year program, the 2011 OVDI is an eight-year program, covering the years 2003 through 2010. However, the IRS will not consider the 2010 year for purposes of calculating the miscellaneous penalty if the taxpayer properly reported, and paid all applicable taxes on his or her foreign assets in 2010.
• 25 Percent Miscellaneous Penalty. Whereas the 2009 OVDP imposed a miscellaneous penalty of 20 percent of the highest aggregate balance/value of the taxpayer’s undisclosed accounts /assets, that penalty has been increased to 25 percent under the new Program.
• New Reduced Penalty Category. The 2011 OVDI has implemented a 12.5 percent miscellaneous penalty (in lieu of the 25 percent penalty) for taxpayers whose highest aggregate account balance never exceeded $75,000 during the period covered by the voluntary disclosure.
• Expanded Criteria for Application of 5 Percent Penalty. The IRS also slightly expanded the situations in which a taxpayer may qualify for a 5 percent miscellaneous penalty (in lieu of the 25 percent penalty). Under the 2009 OVDP, taxpayers could qualify for the reduced penalty only if: (1) they did not open or cause the account(s) to be opened; (2) there was no activity (deposits, withdrawals, etc.) in the account while controlled by the taxpayer; and (3) all applicable taxes were paid on the amounts that funded the account. For funds deposited prior to January 1, 1991, it will be presumed that all applicable taxes were paid on the funds absent evidence to the contrary. This reduced penalty came to be dubbed the “unicorn penalty” because virtually no taxpayer was able to satisfy it. This was especially true given that the IRS took the position that taxpayers whose only activity consisted of withdrawing monies to close the account nevertheless failed to satisfy the second of these criteria.

The 2011 OVDI amended these criteria to permit taxpayers to qualify for the 5 percent penalty if there was only “minimal, infrequent” contact with the account. The 2011 OVDI also specifies that the act of closing the account and moving the funds to the U.S. will not disqualify a taxpayer from the 5 percent penalty (although moving the funds to another offshore account will disqualify a taxpayer). Nor will making withdrawals of less than $1,000 disqualify a taxpayer from meriting the 5 percent penalty. While these changes will no doubt allow some taxpayers to qualify for the 5 percent penalty who otherwise would not have qualified, this exception remains a very narrow one which has been very strictly applied by the IRS in practice.

Finally, the 2011 OVDI creates an additional category of taxpayers who may qualify for the 5 percent reduced penalty: taxpayers who are foreign residents and who were unaware that they were U.S. citizens. Needless to say, it is unlikely that many taxpayers will satisfy this exception either.

How Does the 2011 OVDI Impact the 2009 OVDP?

The 2011 OVDI is a separate program from the 2009 OVDP. Taxpayers who came forward after October 15, 2009 can only qualify for treatment under the 2011 OVDI. However, taxpayers who came forward under the 2009 OVDP may avail themselves of certain terms of the 2011 OVDI. For instance, taxpayers who were not able to take advantage of the reduced 5 percent or 12.5 percent miscellaneous penalties under the 2009 OVDP, but who would qualify under the terms of the 2011 OVDI, may apply for the reduced penalty. This is true even if the taxpayer executed a closing agreement as to their voluntary disclosure under the terms of the old Program.

What Does the Voluntary Disclosure Program Entail?

Practitioners must exercise due diligence in determining the correctness of any oral or written representations made to the client about the Program and the implications for the participating taxpayer. If the taxpayer decides to participate, the practitioner must exercise due diligence in determining the correctness of representations made to the IRS in processing the disclosure and must avoid giving false or misleading information to the IRS or the taxpayer. If the client decides not to participate, Circular 230 requires that the practitioner advise the client of the consequences of non-compliance and prohibits the practitioner from preparing any current tax return or similar form for the non-compliant taxpayer.

The initial FAQ’s issued in connection with the 2011 OVDI stated that practitioners could not prepare the current or future tax returns of a taxpayer who refused to disclose their foreign account without running afoul of Circular 230. The IRS subsequently amended the FAQs only to prohibit a practitioner from preparing a taxpayer’s return for the year in which the taxpayer failed to report the foreign account. One can infer from this modification that the IRS does not believe it is a violation of Circular 230 to prepare future (accurate) returns for taxpayers who previously failed to report their foreign account.

What Happens After August 31, 2011?

Although eligibility for the 2011 OVDI will come to an end on August 31, 2011, the IRS’s voluntary disclosure program continues. Taxpayers may still avoid criminal prosecution by voluntarily reporting their prior tax non-compliance, regardless of whether it involves the failure to disclose foreign accounts. However, such taxpayers will be subject to the full range of statutorily applicable civil penalties. For cases involving undisclosed foreign accounts, this includes the Draconian penalty for willfully failing to file an FBAR, consisting of the greater of $100,000 or 50 percent of the highest aggregate account balance for each violation. Taxpayers who remain on the fence as to whether to come forward under the 2011 OVDI should be made aware of these potential penalties.

¹ Taxpayers who held one or more assets through sham corporations may avoid filing one or more of these forms by filing a “Statement of Dissolved Entities” (a copy of which can be found on the IRS website at http://www.irs.gov/pub/irs-utl/2011ovdidissolutionstatement.pdf) in which the taxpayer takes the position that the entity was nothing more than a sham and that the assets held by the entity should be treated as having been owned individually by the taxpayer.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.

REVIEW QUESTION

How is the 2011 OVDI different from the 2009 ODVI?

1. 2011 OVDI covers years 2003 to 2010
2. The miscellaneous penalty for 2011 OVDI is 25%
3. New 12.5% penalty for aggregate balances not exceeding $75,000
4. All of the above.

Answer: D. All of the above.

Details

Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 15 April 2011

By Sidney Kess, Of Counsel, Kostelanetz & Fink, LLP and Robert S. Fink, partner, Kostelanetz & Fink, LLP

Married couples who file joint income tax returns are jointly and severally liable for the taxes, interest, and penalties (other than the fraud penalty) on those returns (Code Sec. 6013(d)(3)). However, one spouse may be relieved of liability under certain conditions. This relief is generally referred to as “innocent spouse relief.” This article details the conditions for relief, the types of relief available, and some important recent developments on innocent spouse relief.

Overview of Innocent Spouse Relief

Innocent spouse relief is a way for one spouse to avoid some or all of the liability for taxes on a joint return. The innocent spouse relief rules were first enacted in 1971. The initial rules, however, had thresholds for relief that many taxpayers were not able to pass. Over the years, various changes were made, and in 1998, the Internal Revenue Service Restructuring and Reform Act was enacted, which contains the liberalized rules in place today.

Discussed below are three distinct types of innocent spouse relief. Of course, different factual situations demand the application of different types of rules.

The taxpayer must file a timely request for innocent spouse relief. The IRS does not automatically provide relief; it must be requested on Form 8857, Request for Innocent Spouse Relief. This form is not filed with a tax return, but rather, directly with the IRS in Covington, KY, regardless of where a taxpayer has filed his or her tax return.

Types of Innocent Spouse Relief

Below you will find a discussion of the different types of innocent spouse relief:

Basic innocent spouse relief (Code Sec. 6015(b)). A spouse can obtain relief with respect to understated tax or erroneous items as long as you file the request form in a timely manner and send the form to the IRS in Covington, KY. If a spouse knew about some erroneous items but not others, partial relief is allowed. To make a claim for basic innocent spouse relief, all of the following conditions must be met:

• A taxpayer files a joint return which has an understatement of tax due to erroneous items of your spouse (or former spouse). Erroneous items include unreported income or incorrect deductions, credits, or tax basis.

• A taxpayer establishes that at the time the joint return was signed, he or she did not know, and had no reason to know, that there was an understatement of tax. The standard is whether a reasonable person under similar circumstances would have known about the understatement.

• Taking into account all the facts and circumstances, it would be unfair to hold the taxpayer liable for the understatement of tax. These facts and circumstances include a taxpayer’s educational background, business experience, and involvement in the business or transaction, which caused the understatement. The IRS will also look at whether the spouse claiming relief has received a significant benefit from the understatement.

• A request for relief must be filed within two years of when the IRS begins its collection activities.

A request for innocent spouse relief will not be granted if the IRS proves that the taxpayer and spouse (or former spouse) transferred property to one another as part of a fraudulent scheme. A fraudulent scheme includes a scheme to defraud the IRS or another third party (e.g., a creditor, ex-spouse, or business partner).

Separation of liability relief (Code Sec. 6015(c)). This second type of relief applies only to those who are divorced, legally separated, or have lived apart during the 12 months prior to filing this Form 8857. This relief limits the innocent spouse’s liability to the specific liability allocable to said spouse. Thus, if all of the liability on a joint return filed prior to a divorce (separation or living apart) relates to unreported income from the other spouse, then the requesting spouse is fully relieved of liability. However, no relief is granted if, at the time the tax return was signed, there was knowledge by the “innocent” spouse of any item resulting in an understatement; however, partial relief can be granted.

With separation of liability, unlike basic innocent spouse relief, the burden of proof for actual knowledge of the understatement of tax is shifted from the taxpayer to the IRS. Proof by the IRS that the spouse had reason to know of the understatement is insufficient to carry its burden. Moreover, even if the IRS proves actual knowledge, such knowledge is insufficient if the spouse proves that he or she signed the return under duress.

Equitable relief (Code Sec. 6015(f)). Even if a spouse does not meet all of the conditions discussed above, equitable relief can be granted if there is an understated tax or underpaid tax. Taking into account all of the facts and circumstances, it would be unfair to hold the spouse liable for the understated or underpaid tax.  For example, if the “innocent” spouse signs an accurate return but payment is not made because the “guilty” spouse runs away with a lover and the family funds, the “innocent” spouse may be relieved of liability for the unpaid tax.

Relief arising from community property law. Spouses living in community property states may obtain relief from liability arising from community property law.

Recent Developments

Over the years, innocent spouse relief has been subject to considerable litigation. Here are some key issues that have been litigated recently.

Two-year limit. The Tax Code specifically states that there is a two-year period for making a claim for basic innocent spouse relief (Code Sec. 6015(b)(2)) or separation of liability relief (Code Sec. 6015(c)(2)). The Tax Code is silent with regard to equitable relief; however, there are regulations that extend the same two-year period to equitable relief (Reg. § 1.6015-5(b)(1)). In a case of first impression, the Tax Court ruled that the regulations adding the two-year period for equitable relief were invalid (Lantz, 132 TC 139 (2009)). However, the Seventh Circuit reversed that decision (607 F.3d 479 (7th Cir. 2010).

Recently, the Tax Court again had the opportunity to consider the issue and again said that the regulations were an invalid interpretation of the Tax Code (Hall, 135 TC No. 19 (2010). This case is currently on appeal in the Sixth Circuit.

Estate's payment of tax. In another recent case, a husband died and the estate paid the outstanding tax liability. The surviving spouse filed for innocent spouse relief, but the Tax Court denied her claim (Kaufman, TC Memo 2010-89). Since she was not the payor of the taxes, which were paid by the estate, she therefore could not recoup taxes from the government.

Impact of spousal abuse. In one recent case, a wife suffered verbal and physical abuse at the hands of her husband. She earned a small wage in one of the years in question (most of the income was the husband’s). Since she was able to prove the physical abuse that occurred throughout her marriage, the court said that it would be inequitable to hold her liable, even for the amount of tax attributable to her “small” earnings and granted her full relief.

Raising the issue of relief after court action. Can innocent spouse relief be claimed after a couple’s tax liability has been determined by the Tax Court? Apparently, the answer is “yes.”

In a recent case in which a wife and her husband litigated three consolidated cases for tax years 1996, 1997, and 1998 before the Tax Court (Diehl, 134 TC No. 7 (2010), the wife’s attorney raised the issue of relief from joint and several liability under Sec. 6015 in the petition for 1996, but not 1997 or 1998. The request did not specify any subsection of Sec. 6015. The wife then withdrew her claim for relief from joint and several liability in the stipulation of facts for the consolidated cases.

Her husband died after the opinion in the consolidated cases was filed, but before decisions were entered. After decisions were entered, the wife filed an administrative claim for innocent spouse relief for 1996, 1997, and 1998. The Tax Court said that the wife was not barred from electing relief under Sec. 6015(c), for 1996 and also relief under Secs. 6015(b), (c), and (f) for 1997 and 1998.

The IRS argued that res judicata (Code Sec. 6015(g)(2)) bars the wife from claiming relief from joint and several liability for 1996, 1997, and 1998, because the court had entered final decisions for those years. The wife said that res judicata was not an issue because the claim for innocent spouse relief had not been raised when the consolidated cases were decided.

The Tax Court disagreed with the IRS, holding that the wife did not participate in the litigation in a meaningful way, so she was not estopped from pursuing her claims for innocent spouse relief. Since the relief was not sought at the time those cases were considered, she was permitted to seek innocent spouse relief after the decisions had been entered.

IRS Publication 971, Innocent Spouse Relief (www.irs.gov). This publication, last revised in April 2008, contains the basic rules for claiming innocent spouse relief.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.

REVIEW QUESTION

True or False? There is a three-year period for claiming innocent spouse relief.

Answer: False

The Tax Code specifically states that there is a two-year period for making a claim for basic innocent spouse relief (Code Sec. 6015(b)(2)).

Details

Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 13 January 2011

Actions, or inactions, can trigger tax penalties; these penalties can be substantial. Some penalties can be abated under certain circumstances; other penalties can be avoided entirely if proper action is taken.

Joint and Several Liability

Husbands and wives who file joint returns are jointly and severally liable for the tax, interest and penalties related to the returns. However, one spouse can avoid this liability by claiming innocent spouse relief (Code Sec. 6015).

There are three types of innocent spouse relief:

• Basic innocent spouse relief, whether married or now divorced (Code Sec. 6015(b)). The innocent spouse must show that the understatement is due to the other spouse, that he/she had no knowledge of or reason to know of the understatement and did not benefit from it (i.e., it would be inequitable to hold such spouse liable).

• Separate liability for former spouses where one spouse can avoid or limit liability to his/her allocable share (Code Sec. 6015(c)).

• Equitable relief where it is inequitable to hold one spouse liable, given the facts and circumstances (Code Sec. 6015(f)).

To claim innocent spouse relief, an election must be filed no later than two years from the date that the IRS first began collection activities. This is done by filing Form 8857, Innocent Spouse Relief.

The Tax Court had concluded that regulations enforcing the two-year rule in the case of equitable relief were invalid (Lantz, 132 TC No. 8 (2009); the Seventh Circuit, however, recently reversed this holding (CA-7, USTC ¶50,446). Thus, a claim for equitable relief from liability on a joint return can be considered only if the request is timely filed (i.e., within the two-year period).

Innocent spouse relief is discretionary with the IRS; the IRS can even reverse an initial grant of relief (Chief Counsel Advice Memorandum 200802030). The U.S. Tax Court has jurisdiction to review a denial of innocent spouse relief.

Filing Returns

Individual income tax returns that are not filed by the due date (or extended due date if applicable) are subject to a penalty of 5% of the amount of tax shown on the return, up to a maximum of 25% (Code Sec. 6651(a)). If the return is more than 60 days late, the penalty is not less than the lesser of $135 or 100% of the tax due on the return (prior to 2009, it was $100 or 100% of the tax due; Heroes Earnings Assistance and Relief Tax Act of 2008; P.L. 110-245).

The penalty can be waived if it can be shown that the failure was due to reasonable cause and not to willful neglect. The law and regulations do not define reasonable cause, but the Internal Revenue Manual (Handbook) provides some guidance (I.R.M. 20.1.1.3.1.2, February 2008). For example, the Manual recognizes that a taxpayer has an obligation to make reasonable efforts to determine tax rules (including filing returns); in effect, ignorance of the law usually is not an excuse for nonfiling or late filing. However, depending on the circumstances, valid excuses may include health problems of the taxpayer or family member, a death in the family or reliance on the advice of a tax advisor or IRS employee.

Excuses that will not result in a penalty waiver include:

• Illness or death of the taxpayer’s accountant (see e.g., Gale, TC Memo 2002-54; Frank, TC Memo 1982-214).

• Failure to obtain advice (see e.g., Sparkman, TC Memo 2005-136, aff’d on other issues, CA-9, 2008-1 USTC ¶50,102).

Estimated Taxes

Individual income taxes operate on a “pay as you go” system. This requires individuals to pay their taxes through withholding on wages and certain other income and/or quarterly estimated taxes. If there is an underpayment because estimated taxes are not paid at all when they should be or are paid but in insufficient amounts (below “safe harbors”), a penalty results (Code Sec. 6654).

The IRS has discretion to waive the penalty if:

• The failure to make estimated payments is caused by a casualty, disaster or other unusual circumstance, and it would be inequitable to impose the penalty, or

• The taxpayer has retired (after reaching age 62) or becomes disabled during the tax year for which estimated payments were required to be made or in the preceding tax year (Code Sec. 6654(e)(3)). In this instance, the underpayment must be due to reasonable cause and not to willful neglect.

Sometimes, special waivers are granted by the IRS or through legislation because of new tax rules or for other reasons. For example, the IRS said it would not impose underpayment penalties on 2009 income tax returns resulting from the making work pay credit (www.irs.gov/newsroom/article/0,,id=218941,00.html).

Early Withdrawals from Qualified Plans and IRAs

Those who take money from these retirement accounts before age 59½ usually are subject to a 10% early distribution penalty (Code Sec. 72(t)). Thus, in addition to regular taxes on the distributions, there is also a penalty. The penalty can be avoided in a number of circumstances.

Some penalty exceptions apply to both qualified retirement plans and IRAs, some apply only to qualified plans or to IRAs.

Penalty exceptions applicable to both qualified plans and IRAs: distributions on account of death, disability, part of a series of substantially equal periodic payments, medical costs exceeding 7.5% of adjusted gross income qualified reservist distributions or levy by the IRS. From time to time, there may be an exception created for qualified disaster distributions, as was the case with Hurricanes Katrina, Rita and Wilma in 2005 and the Midwestern storms and flooding in 2008.

Penalty exceptions applicable only to qualified plans: distributions following separation from service at age 55 or older and payments to alternate payees (such as former spouses) under qualified domestic relations orders (QDROs). Distributions from a state or local pension plan to a public safety officer after reaching age 50 are also exempt from penalty.

Penalty exceptions applicable only to IRAs: distributions for first-time home-buy costs up to $10,000, higher education costs, payments of health insurance premiums by certain unemployed individuals and transfers incident to divorce.

There is no exception to the penalty from qualified plans or IRAs for financial hardships (see e.g., Dollander, TC Memo 2009-187; Venet, TC Memo 2009-268). Thus, while a 401(k) plan may permit a withdrawal on account of financial hardship prior to age 59½, such distribution is taxable and subject to the 10% early distribution penalty.

Insufficient Distributions

Those who are at least age 70½, as well as beneficiaries, of qualified plans and IRAs who do not take sufficient distributions from these accounts to meet required minimum distribution (RMD) rules are subject to a 50% penalty (Code Sec. 4974). The penalty is 50% of the amount that should have been distributed compared with what, if any, has been distributed.

The RMD rules were suspended for 2009 to give taxpayers an opportunity to have their accounts recover from the stock market collapse (Worker, Retiree, and Employer Recovery Act of 2008, P.L. 110-458); the RMD rules have not been suspended for 2010. There is a special rule for individuals who turned age 70½ in 2009. Normally, their first RMD would be April 1, 2010. However, because of the 2009 suspension, their first RMD deadline is December 31, 2010.

The penalty can be waived by requesting IRS relief, which will be granted if there is reasonable cause for the insufficient withdrawal and steps are being taken by the taxpayer to remedy the situation. The IRS instructs taxpayers to request relief by filing Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and other Tax-Favored Accounts. Enter “RC” on the line next to the penalty, along with the amount to be waived; this reduces the amount of the penalty owed. A letter of explanation should accompany the form. If the IRS does not approve of the excuse, it will send a bill for the additional penalty.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.

REVIEW QUESTION    

A penalty exception for early withdrawal available to both IRAs and qualified plans is financial hardship: True or False

Answer: False

There is no exception to the penalty, according to TC Memo 2009-268. Disaster relief is the penalty exemption for both IRAs and qualified plans.
 

Details

Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 06 December 2010

On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010. In addition to provisions intended to improve access to capital by small businesses and to encourage exporting, the new law contains $12 billion in tax breaks to help businesses and purportedly inspire or make it easier for them to hire workers. The act does not contain any direct tax incentives for hiring. Here is a roundup of the provisions that may be helpful to certain businesses.

Write-Offs for Equipment and Other Capital Expenses

Businesses may be able to deduct entirely or at least substantially accelerate write-offs for the cost of certain equipment or some specific capital improvements rather than having to depreciate them over a number of years. These breaks apply regardless of how the purchase is financed; they can be claimed whether the equipment is paid for up front or financed in whole or in part.

First-year expensing (“Section 179 deduction”). The dollar limit on writing off the cost of equipment purchases for a business in 2010 and 2011 is increased to $500,000; it was previously at $250,000 in 2010 and $25,000 in 2011 (Code Sec. 179). The dollar limit would begin to phase out when total purchases exceed $2 million, instead of the former $800,000 threshold.

The expensing rule applies not only to equipment and machinery (whether new or pre-owned), but also to qualified leasehold improvements, restaurant improvements and retail improvements up to $250,000.

Normally, the cost of off-the-shelf software must be written off over 36 months. However, for purposes before 2012, the cost can be treated as qualified property for purposes of the first-year expensing deduction.

The opportunity to revoke or make an expensing election without IRS consent applies through 2011; this election option was previously set to apply only through 2010.

Bonus depreciation. The 50% bonus depreciation rule has been extended through 2010 (Code Sec. 168(k)). This allows half of the cost of qualified property to be deducted in the year of purchase. Bonus depreciation can be claimed in addition to first-year expensing.

Depreciation for the purchase of cars, light trucks and vans is limited each year to a dollar amount (Code Sec. 280F). However, new cars, light trucks and vans purchased in 2010 qualify for an additional $8,000 write-off in the first year because of bonus depreciation. For example, if a new business car is bought in 2010 and used 100% for business, a depreciation deduction of up to $11,060 can be claimed. (Dollar limits for cars, light trucks and vans can be found in Rev. Proc. 2010-18, IRB 2010-9, 427.)

Promoting Entrepreneurship

The new law contains several measures intended to encourage business formation.

Start-up costs. Businesses can elect to deduct start-up costs up to a set dollar limit in their first year of operation (Code Sec. 195). Start-up costs include certain expenses incurred before a business opens its doors, such as:

• Costs for an analysis or survey of potential markets, products, labor supply and transportation facilities.
• Advertisements of the business’ opening.
• Salary and wages paid to employees and their instructors for training.
• Travel costs for securing prospective distributors, suppliers and customers.
• Fees to consultants for professional services.

Start-up costs do not include deductible interest, taxes, or research costs.

For start-up costs incurred after October 22, 2004, the first-year deduction limit has been $5,000; the new law doubles it to $10,000 beginning in 2010. Excess amounts are amortized over 180 months.

The dollar limit is phased out when total start-up costs exceed a set amount. That threshold amount had been $50,000; it has been raised to $60,000. Thus, if start-up costs exceed $70,000, the entire amount must be amortized over 180 months.

Exclusion for gain from the sale of qualified small business stock. Investors who purchase stock in certain small corporations are rewarded by being allowed to exclude a certain percentage of their gain if they meet set requirements (Code Sec. 1202). Under the new law, investors who purchase qualified business stock that is issued after September 27, 2010, and before January 1, 2011, and hold it for at least five years, will not pay any capital gains on the sale of the stock (Code Sec. 1202); there is 100% exclusion. Qualified small business stock is stock in a C corporation (not an S corporation) that has gross assets when the stock is issued of not more than $50 million. The corporation must be an active trade or business.

For stock issued after February 17, 2009, and before September 28, 2010, the exclusion is 75% of the gain. Prior to this time, the exclusion had been set at 50% of the gain (or 60% of the gain for stock of businesses located within certain economically-distressed areas).

The exclusion applies not only for regular income tax purposes but also for purposes of the alternative minimum tax.

Reduction in the built-in gains period for S corporations. When a corporation that has been operating as a C corporation converts to S status, any appreciation within its assets will be taxed to the S corporation as built-in gains if sold within a set period. Usually, the built-in gains tax period is 10 years (Code Sec. 1374). For tax years beginning in 2009 and 2010, the period is reduced to seven years; for tax years beginning in 2011, the period is reduced to five years.

Other Helpful Changes

Self-employed health insurance deduction. Health insurance premiums paid by a self-employed person (or a more-than-2% S corporation shareholder) are deductible only as a personal deduction; it is subtracted from gross income. (It is not an itemized deduction.) However, for 2010 only, such premiums are deductible for self-employment tax purposes. This means that the premiums reduce net earnings from self-employment for purposes of self-employment tax.

For example, if a self-employed individual pays health insurance premiums in 2010 of $12,000 for herself and her family, she saves approximately $1,800 in self-employment tax.

Carryback of the general business credit. The general business credit is not a separate credit; it is the conglomeration of certain business credits into one unit, with a single carryback period and carryover period (Code Sec. 39). The general business credit may not exceed the taxpayer’s net income over the greater of the taxpayer’s tentative minimum tax or 25% of the regular tax in excess of $25,000. Usually, excess credit amounts can be carried back for one year and forward for up to 20 years. Under the new law, the carryback period is extended to five years for eligible small businesses.

Eligible small businesses mean a privately-held corporation, partnership or sole proprietorship with average annual gross receipts in the three prior years not exceeding $50 million.

This longer carryback period applies to credits in a business’ first taxable year beginning after December 31, 2009 (i.e., 2010 for calendar-year businesses).

Also, the general business credit of an eligible small business can be used to offset the alternative minimum tax (Code Sec. 38).

Cell phones. These are no longer considered “listed property,” which requires special recordkeeping and deductions which cannot be accelerated without business usage being more than 50% of total usage. This rule applies starting this year.

Revenue Raisers

To help pay for the tax cuts, the new law contains a number of revenue raisers. Some apply only to very large corporations or businesses engaged in specific industries. Two revenue raisers with more general application include:

Rollovers to Roth accounts. Amounts from qualified retirement plans can be rolled over to Roth 401(k) accounts, effective after September 27, 2010 (Code Sec. 402A). When these rollovers are made, plan participants must include the rollover amounts in income.

Reporting by rental property owners. To help pay for the tax cuts, as a revenue raiser, those in the business of rental real estate must issue Form 1099s to service providers starting in 2011 (Code Sec. 6041). Service providers include painters, plumbers, accountants and anyone else providing services to rental properties.

Excluded Provisions

During the legislative process, a number of revenue raisers had been discussed but were not included in the final bill. These include:

• Changes to carried interest rules. Currently, this type of compensation paid to equity fund managers is treated as capital gain; proposed changes would have treated a certain percentage of this compensation as ordinary income.

• Changes to grantor retained annuity trusts (GRATs). A GRAT is a trust that pays the grantor an annuity from the trust for a set period, after which the balance of the trust is payable to named beneficiaries at reduced gift tax cost. Proposed changes would have required that the retained annuity interest be for a term of not less than 10 years, that the annuity would not decline during this term and that the remainder interest passing to beneficiaries has a value greater than zero at the time of the transfer.

Note: Future legislation may include these revenue raisers.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.